Let me start with a little history, one distant example, one recent. Both relate to incentives. In the 18th century, we exported our criminals to Australia, and paid on the basis of every convict shipped aboard at the quayside at Bristol or London. On average, 12 per cent of those who were shipped aboard in Britain died en route; on some voyages more than one in three of those shipped died before reaching Australia. In 1792, the system was changed (according to some reports, on the suggestion of Jeremy Bentham). Shippers were paid for every convict delivered alive in Australia, rather than shipped aboard in Britain. In 1793, three convict ships sailed to Australia transporting 422 convicts, of whom 421 were delivered alive – a mortality rate about 1/50th of what had previously occurred. The new reward structure produced immediate and dramatic change. My second example is much more recent and relates to the opening of the retail market for gas and electricity in the UK to competition in the late 1990s. In practice this was done by door to door salesmen and women, on commission. Originally, all the energy companies paid their sales forces against signed contracts to buy gas and electricity, with the result that there were numerous abuses: forged signatures, signatures from children, incorrect claims of the savings from benefits, disputed contracts. Eventually (and with some regulatory encouragement), all the energy companies changed to paying commission against signed contracts only after they had been subsequently confirmed by the customer, and abuses essentially stopped – not because door to door salesmen and women had become more ethical, but because it was not profitable to cheat. My first point is, quite simply, incentives matter. They change behaviour.
Against that statement that incentives matter, let me look at the distribution system for financial services to retail customers. My contention is that we have a system which serves neither the producer of the services nor the consumer of the services. It is doubtful whether it serves the intermediary either.
I assume that the provider of the retail financial service wants over time to associate his or her brand with qualities of reliability, trustworthiness, performance, and to establish and develop a long term relationship with customers, so that they can benefit from those parts of the customer's life when he or she is accumulating wealth. If this is the aim, what we have fails miserably:
- The present distribution system is distinguished by a focus on business volume rather than quality. Symptoms of this are the attention still given to Annual Premium Equivalent (APE) as a measure of business success. My fellow panellist Ned Cazalet has highlighted the very significant volumes of transfers between provider firms in the pensions market, which amount to about half of new single premium personal pensions. Such transfers add to the APE numbers, but can give a false impression of how much actual new revenue is coming into the industry as a significant proportion of so-called 'new' business would appear to be regular premiums and single premiums that have been transferred from other providers. This 'merry go round' as it has been so characterised, not only reduces, if not eliminates, the profitability of the business, it also proves a major obstacle to firms establishing long-term relationships with their customers. Questions also have to be asked as to how much of this recycled business is of negligible advantage to the customer.
- So, not surprisingly, persistency of policies is low with, for example, around half of customers who buy regular premium personal pensions no longer paying into them after four years. Given the structure of commission, the fact that around one in six of those who take out a regular premium personal pension stop contributing to it after one year means that many may be penalised. Indeed, one has to question whether products that are subject to that level of attrition should be designed, priced and marketed – and, of course, generate commission – as if they were long term regular premium products at all.
- These points strongly suggest that while there is clearly a lot of activity in the pensions market, it is not clear how much is motivated by the customer's best interests. I recognise, of course, that there are entirely legitimate circumstances in which transactions with limited life will properly occur – for example, change in employer, dissatisfaction with current investment performance and so on. Others, however, will be conspicuous examples of either mis-buying, or mis-selling, or some combination of the two. Where this is the case, it has to be recognised that frictional costs associated with such transactions will inevitably take out value from the system. In turn, this will diminish, and may eliminate entirely, returns for providers and customers. Arguably, distributors suffer too. The sum picture is one that is incompatible with developing either a reputation for the industry as a whole, or a brand reputation for individual companies.
The consumer does no better than the providers under the present remuneration model. This suffers from product bias, provider bias and churn. Product bias - in other words, the customer not being advised to take action consistent with their priority needs - is arguably the most detrimental. Consumers are not always advised on transactions which fail to remunerate the adviser, or which offer little by way of commission to the adviser. So, for instance there is a dearth of advice on paying off debt or the course of action to take with with profits policies, and national savings and investment trusts are neglected. Provider bias is clear: I am struck by the prevalence of examples of providers managing demand – up or down – by adjusting commissions which can lead to less suitable or even unsuitable sales. Linked to provider bias is churn, with the potential for significant consumer detriment from paying unnecessary commissions, charges or fees when induced to switch from one product to another despite the benefits of such a move – if they exist – only materialising after a long period during which the switch has been to the consumer's detriment. So the consumer does badly from the present business model too. Please note that I am not saying that commission as an incentive is necessarily bad – but at present it is clear that the way in which firms are managed when the commission model applies frequently fails to mitigate these high risks of inappropriate advisory and transactional activities taking place.
It is often claimed that the beneficiary of the present model is the intermediary who advises on the sale. I think this is a proposition which needs further probing. The present system, with its in built encouragement to churn and its product and provider bias, is not one which is naturally robust to claims for mis selling, and the associated compensation liabilities. I note that as at May 2006, the top 21 IFAs had turnover of £640 million, but operating losses of £22 million – twice that of a year earlier. So I don't think we should assume that the present model is good for even the intermediaries.
So my second point is that we have at present a business model which is based on incentives which produce results which are unattractive to reputable providers, unattractive to their customers, and whose benefits to intermediaries are questionable. What are we going to do to change it?
Of course, some of the responsibility for the evolution of this unhealthy model must lie with the legislative and regulatory policies of the past quarter century. In a moment, I will discuss the regulatory initiatives being taken by the FSA, designed to make the market work more effectively. But the solution to the problem must lie principally with the industry. And one of the key questions that must be addressed is this: who is the real customer of the provider – is it the policyholder who invests their money in the hope of seeing a decent return? Or is it the distributor, who in the main, secures access to the end-consumer for the provider? If, as many commentators would have it, it is indeed the distributor who is the actual customer of the provider, this raises all manner of difficulties which further perpetuate the shortcomings of the current model – particularly with regard to treating the real customer fairly. I understand well that many are frustrated by what they describe as the "commission stranglehold" that the advisory community enjoys, but so long as providers continue to compete over the attractiveness of their commission proposition, the fundamental flaws in the present business model will remain.
Of course, while it is right and proper that the industry take responsibility for the business model that it chooses to operate under and the implications of the attendant incentives, the FSA also has a role to play. It will I hope help if I indicate the work which we are considering as our contribution to changing a highly unsatisfactory position. It falls into three parts.
The first is very long term, and relates to our work on promoting financial capability. One of the fundamental problems of the retail market for financial services – for both provider and consumer – is the information asymmetry between provider and customer, which derives in part from the very low levels of financial capability among the adult population (I say in part because there are other factors, such as the extended time span for judging the performance of a financial product). The FSA's work on financial capability will always be a small adjunct to the government's spend – currently over £42 billion a year on UK education (pre-school, primary and secondary) – to discharge its responsibility to produce literate and numerate citizens. Our challenge is to find where the FSA's spend on financial capability can have a catalytic effect. We have increased our effort here: I expect the FSA's spend on financial capability this year to be £11 million and to run in future years in the range £15 20 million, against £2 million in 2003-04. But, seriously though we are taking this, and important though it is, it will take a decade or more to really work through to being effective.
The second strand of work is what we at the FSA could or should do to provide incentives to firms to develop a business model for the retail financial market which works better than the present model. There are some particular initiatives, which all derive from the treating customers fairly (TCF) programme. We are concerned about the remuneration practices which we have found in many firms which profess to have embraced the principle of TCF, but where the practice appears to run counter to the principle. For example, our recent thematic work on the quality of advice at financial advisers found that:
- for non sales personnel, at and above managers, bonuses are often linked to growth and profit targets, unadjusted for customer issues;
- for sales personnel, there is a raft of detailed sales commissions which taken in the context of overall performance management frameworks do little to encourage (and may discourage) the fair treatment of customers.
So the first initiative is to encourage firms to develop practices which reinforce, rather than undermine, the principle of treating customers fairly and to take steps to mitigate the risks of unsuitable advice as a result of inappropriate management of performance and reward. Second, there are a number of issues connected to the advice process, where again firms need to adopt practices which deliver TCF. For example:
- only a third of firms' advisers provided non commission earning advice before moving on to commission-earning transactions, and of firms which held themselves out as offering a full advice service only a third obtained the information from the customer which would enable them to do so properly;
- there are substantial failings in the recruitment, training and assessment of advisers.
We need to see an advisory process which supports treating customers fairly. Too often it does not.
Allied to this, we are also working to establish a better recognition of the responsibilities which exist between different parts of the distribution chain, and in particular between the product provider and the distributor of the product, or a derived product. This is not a simple area, since there are many relationships between product providers and distributors. A capital protected structured retail product – the currently popular guaranteed return bond for example – could involve one or more investment banks providing structured derivatives and trading in both equities and bonds; a retail bank which attaches its name to the product; and a distribution network of IFAs. We need a clearer recognition of where responsibilities lie. In particular, we need to avoid a position in which the use of IFAs as a distribution channel acts as a "cut off", shielding the relevant product provider – in this example the retail bank – from any responsibility for treating customers fairly. We plan to publish a consultation paper on these issues before the end of September. By teasing out responsibility in a number of examples, we are trying to give greater clarity on how we will interpret principles, mainly but not only treating customers fairly, in what is a complex area.
The final stream of work that I want to mention today aims to move beyond simply identifying issues and symptoms – important though that is – and instead seeks to address the root causes. Given the central importance of a financial sector that is able to provide the right kind of products in the right way and at the right time to those that need them, we believe now is the time to take a step back and consider the wider context of the distribution of retail financial products. To that end, the Retail Distribution Review announced by John Tiner in June is now well under way, with the team busy meeting with the market and professional bodies to hear their views on the issues that need to be given consideration. We are ourselves analysing, for various retail financial services, the value chain: who are the players? How much does each pay, and how? Who makes money? Where does regulation impose costs and where does it add benefits? What are the barriers to market solutions to the points I've raised today? In particular, we need to have a better understanding of the costs and the profitability of the business, the sustainability of the current structure, and assess how far those costs are associated with regulation. This will take into account our earlier work on the costs of regulation and I don't want to prejudge the results of this wider review. But we do need to identify regulations in this sector whose costs outweigh their benefits (in which case we will seek to change them) or not, as the case may be. I am doubtful whether lower regulatory costs will constitute a major opportunity for cost reduction, or for major change to the business model. Indeed, we expect that many of our regulations have longer term commercial benefits that more enlightened firms have already recognised for themselves.
We plan to announce the shape and scope of the Review in early November informed by our work with the market. But I can tell you today that as well as covering efficiency issues, including the economics around distribution channels - and necessarily, the impact of the way that commissions are paid - the Review will also explore the extent to which the market is able to provide and sustain good quality professional advice.
I have set out how we at the FSA are approaching a business model and business practices which leave much to be desired from the viewpoint of certainly provider and of customer and – arguably – of intermediary as well. But the main response must come from the industry itself. I, along with everyone else, welcome the ABI's recently launched Customer Impact Scheme as a step in the right direction for the many life insurers who have signed up to this initiative. But given the gravity of the shortcomings I have pointed to today, I also have to question whether this step is sufficiently purposeful to make a difference on the scale required. I come back to my earlier statement. The principal responsibility for the business model used by firms lies with the firms which use it. I have identified a number of severe failings in the present model, which make it appear unattractive to both providers and consumers of financial services. I have set out what the FSA intends to do. I will be very interested in seeing whether the industry can develop a full and appropriate response – something which would appear entirely in keeping with their repeated statements about their wish to improve their brand and their performance.
